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Question from Past Microeconomics Qualifying ExamEdit

Spring 2004 - Section I, Question six, George Mason University

State first whether the following statement is true, false or uncertain. Then briefly explain your reasoning in four or five sentences. You may use a graph if it helps clarify your answer.

Argentina, a major wine producing country, recently devalued its currency which led to an immediate fall in its domestic interest rates. It will lead to higher quality Argentinian wines.

AnswerEdit

True (in a closed economy). Wine is a product generally held to improve with age. After a drop in the interest rate, risky investments in higher-quality wines (these investments are effected by delaying consumption) appear increasingly attractive relative to selling the wines today and saving the money to earn the going rate of interest.

False (in an open economy). Under the Mundell-Fleming Model, capital will flow out of Argentina, seeking higher interest rates elsewhere. Because of the increase in the real exchange rate (fall in the domestic currency), net exports increase, as consumers at home and abroad seek to purchase less expensive domestic goods. This increase in demand brings the domestic interest rate back into line with the world interest rate. The end result is higher sales of Argentinian products; assuming that Argentinian wine is no exception, with greater amounts sold and consumed, it seems plausible to expect that its average quality will fall in the short run.

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